Living on borrowed time when interest rates rise

Things may look fine now but change is inevitable. Will your investing approach stay on the money?

Interest rates are predicted to rise across the western world at the time of writing. In the US and UK, futures markets have priced in a half-point rise by the end of 2019. Even in the euro zone, market watchers expect rate rises by then. For many borrowers, this will be an unwelcome novelty.

In the UK, the last significant series of rate rises was as long ago as 2006-07. In the US, they came in 2004-06. Anybody who took out a mortgage in 2007 in their mid-30s will be pushing 50 before they experience significant rises in mortgage costs.

Climate change
But it might still come as a shock – simply because in 2018 people have become accustomed to rock-bottom rates. Such acclimation is a powerful psychological force. Andrew Clark at the Paris School of Economics has shown that people adapt completely to life-changing events, such as marriage, the birth of a child, or widowhood, in the sense that these do not permanently change our happiness.

It’s likely, therefore, that many have also become used to low borrowing costs. For many, this habituation is reinforced by another mechanism – that our perceptions of the economy are shaped by the experiences of our formative years. Yale University’s Ulrike Malmendier has shown that investors who experienced recessions when they were younger invest less in equities, even decades later, than those who saw better times.

And, she shows, chief executives who saw recessions when they were young run their companies more conservatively.

Short memories
Anybody under 30 in 2018 spent his or her entire adult life with low or falling interest rates. They can be forgiven for thinking such rates are normal, just as those of us who grew up in the 70s and 80s thought of high rates as normal.

Becoming accustomed to the economic climate can be dangerous. The late Hyman Minsky showed why: once people get used to economic stability, they start to take more risks because they forget that crises are possible.

Becoming accustomed to the economic climate can be dangerous. The late Hyman Minsky showed why.

People may borrow more heavily or invest in risky ventures, and banks might lend more. This increases the chance of a financial crisis.

Stability, notes Minsky, can be destabilising. Similarly, some borrowers, having become used to low rates, might have taken on too much debt – and be unable to cope with rising rates.

Shock of the new
You might object that rate rises are typically small and gradual. But this doesn’t mean they’ll be inconsequential. Psychological research tells us that people are more responsive to proportionate changes than absolute ones: this is called the Weber-Fechner law.

A rise in rates from 0.5 to one percent might well seem more shocking than,say, one from 5.5 to six percent. All this has a worrying implication. It suggests that even small rises in interest rates can have larger than usual effects on spending because the shock value can jolt people into spending less.

Historically, rate rises have had only small effects on the economy: Bank of England research shows that a half-point rise cuts output by only around 0.3%. But rises might still, however, have a bigger impact.

There, there …
Central banks know this. At the time of writing, both the Bank of England and Federal Reserve had been saying for months that rate rises would be gradual. A big reason was to try to reduce any shock impact. Only time can tell whether such soothing words succeed.

Obviously, if you are highly indebted you can only do a lot about it if you have time to do so – though you should ensure that your borrowing costs are as low as possible (hint: credit card debt isn’t usually a good idea).

If you have a choice, though, this is a case for holding cash and not being fully invested in equities. Cash does more than simply benefit from higher rates. It also defends us from any falls in share prices if and when investors worry about the impact of higher rates.